Accounting Methods

Zeshan Momin July 12, 2011 — 538 views

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An accounting method is the method that a company or individual chooses to book transactions and prepare financial statements. There are two types of accounting methods: cash basis and accrual accounting. The main difference between the two is the way the company books the receipt of and the paying of cash from the business. The choice of accounting method can lead to very different looking financial statements.

Cash basis accounting

Companies that use the cash basis accounting method book their income when they actually receive the cash and not when they conduct the transaction. They also book expenses when they physically pay the cash rather than when the transaction was conducted. Let's take a look at an example; Company A uses the cash basis accounting method. They enter into a contract to buy 100 widgets for $1 each on May 1st. The widgets are delivered the same day but the invoice is not due until May 31st. In this example, May 1st is the date they entered into the contract and received the goods, while May 31st is the date that will actually be recorded in the accounting books of the company since that is the date they actually paid the cash. Cash in this sense does not only mean the paper money, it means any liquid (easily transferable, widely accepted form of payment) form of payment which can include checks, and other liquid financial instruments. Usually one will find sole proprietors and other small companies employing the cash basis accounting method.

Accrual accounting

Companies that use accrual accounting method book their income on the date of the transaction rather than the date of receipt of cash. They also book their expenses on the date of the transaction rather than the date of payment of cash. In other words, the company would record the transaction when the work was completed and not when the payment was made. Using the same example above, if Company A used the accrual accounting method it would book the expense on the date it entered into the contract and received the widgets- May 1st. It would still make the payment on May 31st as instructed in the invoice. Medium to large sized companies usually use the accrual accounting method. This method is best suited to meet the GAAP (Generally Accepted Accounting Principles).

The impact of each method on financial statements

Depending on which accounting method a company uses, the financial statements can look quite different. The difference comes when there is a difference in the period of receipt/ payment of cash and the period of the completion of the transaction.

In cash basis accounting the income and expenses are rarely matched every month. It is harder to track the differences than in accrual accounting. For example, Company A can enter into a contract to buy 100 widgets on December 20th and receive them the same day. Company A would then make the payment on January 10th the following year. In this case there is a difference in the month of the transaction and in some cases (depending on the fiscal year- more on that in another article) there is a difference in the year of the transaction as well. Company A would receive the goods on December 20th and record the transaction on January 10th. This affects the tax bill as well (in some cases positively, in other cases negatively). There is another possible benefit in employing cash basis accounting. This accounting method is very good in keeping track of cash.

In accrual accounting, the company is able to match income and expenses which allows it to keep track of and have a better understanding of the health of the business. Using the same example of Company A, we can see that the transaction would be recorded on December 20th (not January 10th). The company would make entries in expectance of the payment on January 10th. This way, at the end of the year the company and its stakeholders have a better understanding of the health of the company. However, in this method the company has to engage in some extra procedures to track its cash movements.

There are a few other ways that the two methods impact the financial statements of companies, but these are out of the scope of this article as this was only meant as a primer into the subject.

Zeshan Momin has considerable experience in Accounting and Finance. He is a consultant that helps companies manage their foreign exchange risk exposure. His other interests are electronics, specifically electric testing products like the Fluke 87.